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Stocks: Is It Time to Start Betting on a Recovery?

As some economists grow excited about prospects for recovery by yearend, here are some sectors and trends to watch. Cautions, too

Eventually the economy will bounce back. In fact, many investors are already trying to figure out how to profit from a U.S. economic revival.

This may seem outlandish to Americans suffering from job losses in the biggest economic shock in a lifetime. However, some better-than-expected economic data in recent weeks has bolstered the case of optimistic economists. Data on housing, durable goods orders and retail sales were bad, but weren't quite as weak as expected.

"We're clearly still in decline," says Michael Englund, chief economist for Action Economics. But the decline has slowed. "At least the pace of collapse seems to have stalled." Unemployment might rise to 10% by November or December, but Englund predicts the economy could stop shrinking and start growing again by late summer or early fall.

Double-digit growth in 1934

Even the Great Depression was followed by a strong rebound, says Paul Kasriel, director of economic research at the Northern Trust Company (NTRS). After a devastating decline from 1929 to 1933, the economy found a way to stabilize in 1933, despite serious problems that were far worse than our predicaments, Kasriel said in a speech at a CFA Institute conference on Mar. 25. Given challenges that include misguided central bankers, major tax increases, and a collapse in global trade, he said, "It's amazing to me the economy recovered in 1933."

In 1934 the U.S. economy posted double-digit growth. (But there came a further economic slide a few years later.)

Investors who time the recovery correctly can do well, even in bleak times. The Dow Jones industrial average jumped 67% in 1933, more than in any single year since.

Market professionals are just beginning to sketch out what a post-recession economy and stock market might look like. Those investors who do best in a recovery will be those who can correctly predict features of the recovery: Which sectors bounce back first? Will the recovery be strong and sudden or anemic and slow?

Economists and market experts admit there is plenty of uncertainty in their economic forecasts. Here are the sectors and other trends to watch:

1. Housing

New data on Mar. 25 showed new home sales rose 4.7% in February. Existing home sales had jumped 5.1%.

Most economists and investors believe the housing market will need to stabilize before the economy can recover. But a full-scale recovery for housing could take years. Keith Hembre, chief economist at First American Funds, warns it could be "several years before it's a good environment for homebuilders."

The problem is the huge amount of inventory on the market. As for the latest figures, Englund warns that February sales were helped by warmer, drier weather.

Housing could hit bottom in 2010 but might stay there for a while, says Kasriel. Many who have delayed selling their homes might do so when they see signs of life in the market. "Once demand starts to pick up, you're going to see another wave of supply come on the market," Kasriel says.

The big homebuilders that could benefit from a true housing recovery include D.R. Horton (DHI), Toll Brothers (TOL) and Pulte Homes (PHM).

2. Financials

Recently, the financial sector has led the stock market higher. But Wayne Titche, chief investment officer at AMBS Investments, warns that the financial sector rally may not be sustainable in the long term. "They still have a lot of issues," he says. Some of the stronger financial stocks may be good bets, but they could have a wild ride. "You have to have a strong stomach," he warns.

The financial sector is shrinking as a portion of the economy, and its future growth may be much slower, says Gary Wolfer, chief economist at Univest Wealth Management & Trust (UVSP). Financials also have an image problem with investors, given the huge mistakes—and in some cases, fraud— that caused the subprime mortgage crisis. "It's going to take a little time for people to embrace financial stocks," he says.

3. Consumers

The U.S. consumer has borrowed too much and saved too little, many economists say. In the long term, this must reverse itself. "We are going to rediscover that old-fashioned concept called thrift," Kasriel says.

As a result, the U.S. economy might be less reliant on consumers in the future—a negative for stocks that rely on consumer discretionary spending. But it's an open question as to when this shift will begin to occur.

The federal government is trying to revive consumer spending through tax cuts and other stimulus efforts. At the same time, spending could be slashed further as the unemployment rate continues to rise, even after the economy starts growing again.

Wolfer predicts a "jobless recovery." Eventually, he says: "Consumers will come out of their shell, but they won't be the big spenders that they have been." If present trends continue, this should benefit retailers of necessities such as Wal-Mart (WMT), which has seen steady sales by emphasizing low prices.

4. Export-driven companies

If consumer spending declines as a percentage of the economy, the U.S. will need to rely on other areas to make up for it. In the short term, the Obama Administration hopes that government spending will prop up the economy. In the long term, many say exports will need to be a prime source of growth.

Here the big wildcard is not the U.S. economy, but the global economy—particularly China's. "We're paying a lot of attention to demand from overseas," says Quincy Krosby, chief investment strategist at Hartford (HIG). If emerging economies recover and the dollar weakens, U.S. companies that rely on exports could benefit, she says.

Caterpillar (CAT), a maker of construction equipment, gained from the infrastructure boom in emerging economies but faltered when their growth slowed.

5. Government Policies

Economists and investors disagree about the impact of government policies on the economy. Hembre expects companies to benefit from infrastructure spending as part of the U.S. government's stimulus package. But Englund believes the spending won't have much impact for years.

Likewise, many worry about the effect of higher taxes in the U.S., particularly on the wealthy. Others, however, say the proposed tax hikes are relatively modest.

6. Bankruptcies

Titche warns that the U.S. economic recovery could be quite weak. "It may even be so weak that a lot of people complain that there is no recovery," he says.

In that case, many companies—particularly those with heavy debt loads—won't survive. "You need to be much more careful about the investments you make," Titche says.

He advises seeking out higher quality stocks in every sector. In other words, he says: "Kohl's (KSS) instead of Sears (SHLD), Staples (SPLS) instead of Office Depot (ODP) or Office Max (OMX). and IBM (IBM) instead of Dell (DELL)." (Titche's funds own Kohl's, Staples, and IBM.)

7. Earnings

There's a legitimate debate as to whether the stock market will be able to maintain its momentum even if the economy is on the road to recovery.

Hembre doubts it. With inflation low and growth slow, corporate earnings could be squeezed, he says. Market analysts often repeat the conventional wisdom that the stock market moves higher about six months before the economy recovers. That's not always the case: In the last recession, which ended in 2001, the stock market didn't hit bottom until 2003.

Hembre says that if earnings are stagnant, this decade might be like the period from 1967 to 1982, when stocks went nowhere. "Even though the economy grew substantially in that period, the equity market didn't," he says.

"all clear" is not in sight

So many open questions are a main reason why few investors are confident that the stock market's recent rally truly signals an end to the market misery. "We don't believe happy days are here again," Titche says.

Even if the economy's growth rate turns positive this year—a big 'if'—the market must still deal with such fundamental problems as bankruptcies, stagnant earnings, a global slowdown, excess housing supply, and job losses.

A stabilized economy would be something to celebrate, but it wouldn't by any stretch amount to an "all clear" signal for investors.

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